POB and AICPA Issue Controversial Recommendations

Edward E. Nusbaum

Edward E. Nuabaum is a partner and national director of accounting and auditing for Grant Thornton. In this position, he is responsible for all accounting and auditing policies and overseeing all technical matters for clients. He is a fonner member of the Auditing Standcvds Board (ASB) of the American Znatitute of Cert$ed Public h u n t a n t s and the AICPA Audit Issues Task Force.

he S&L crisis and more recent revelations of management fraud and subsequent failures of some publicly held Companies T have resulted in attacks on the accounting profession and a

loss in the public’s confidence in the integrity of audited financial statements. Two recent initiatives attempt to respond to those concerns. The Public Oversight Board (POB), which was created in 1977 by the American Institute of Certified Public Accountants (AICPA) to oversee and report on the AICPA’s Peer Review Program for firms auditing public entities, issued a special report in March 1993, “Issues Confronting the Accounting Profession.” In addition, in June 1993, the AICPA’s board of directors issued a position statement, “Meeting the Financial Reporting Needs of the Future: A Public Commitment from the Public Accounting Profession.” Both are intended to deal with the public’s concerns and to improve financial reporting. “he recommendations made by both bodies primarily address actions to be taken by the public accounting profession, but many will have implications on actions of management and audit committees.

The Public Oversight Board‘s report discusses recommendations related to litigation, self-regulation, improvements to standards for financial statements and audit reports, and other recommendations to improve and strengthen performance. The AICPA’s statement endorses many of the POB’s recommendations and makes some additional recommendations.

THE LITIGATION CRISIS When creditors and investors sue a company that has failed or one

whose stock price or earnings dropped significantly as a result of revelations about management fraud or other adverse events, they often name the auditors in their suit along with the company’s officers, directors, and others. The suits usually charge that the financial statements should have disclosed those adverse events.

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Frequently, the auditors will eventually be found innocent, but not until after incurring great expense to defend themselves. Unfortunately, auditors are often held responsible or accountable for the misdeeds of others.

The POB believes that such exposure to liability poses significant dangers for the accounting profession’s ability to perform its assigned role in society. However, the POB’s report states that threat of liability may in the long run also affect the public. For example, although accountants have the expertise and objectivity to evaluate forward-looking financial information, which may be useful to users, they are reluctant to be associated with it because of the threat of litigation. Further, many accounting firms now refuse to audit small emerging companies, which have a greater tendency to fail and thus pose a higher risk, so such companies may find it more difficult to have access to the credit and equity markets.

The POB report makes three recommendations related to litigation against auditors. First, it recommends that damages be allocated based on “separate and proportionate liability,” under which the proportion of loss caused by each defendant is determined and damages are allocated accordingly. Under the current method ofjoint and several liability, each defendant is liable for the full loss if other defendants are unable to pay. Second, the report recommends that the civil liability provisions of the Racketeer Influenced and Corrupt Organization Act be amended to eliminate the requirement for treble damages in cases related to federal securities laws. The third recommendation relates to legislation permitting accounting firms to operate in a manner that will limit individual members’ liability, such as the corporate form.

The AICPA also urges that the current doctrine of joint and several liability be replaced with proportionate liability except in cases of “knowing fraud.” It supports the POBs recommendation for accountants to practice in the corporate form. In addition, the AICPA recommends that all litigation in federal and state courts related to the same audit failure be consolidated into one federal suit.

SELF-REGULATION The AICPA’s self-regulatory program was started in 1977. It is

organized under the Division of CPA Firms, which is divided into (1) the Private Companies Practice Section for firms that do not audit clients filingwith the SEC and (2) the SEC Practice Section for firms auditing clients that report to the SEC. The latter self-regulatory program is overseen by the Public Oversight Board.

All AICPA members auditingpublic companies must belong to the SEC Practice Section and must undergo a triennial peer review conducted by a team of experienced auditors from another section member. The section’s Peer Review Committee administers the Peer Review Program. Another committee, the Quality Control Inquiry Committee (QCIC), investigates allegations of audit deficiencies against member firms in connection with civil suits or criminal

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indictments. Although the overwhelming majority of SEC registrants are audited by members of the SEC Practice Section, and therefore undergo peer reviews, a few sole practitioners and small firms continue to avoid section membership and peer reviews. To deal with that problem, the report recommends that the SEC amend its rules to require registrants to disclose whether their auditors have had a peer review, the latest date, and the results.

The report also discusses and rejects suggestions that the accounting profession replace the POB with an organization patterned after the National Association of Security Dealers or the National Transportation Standards Board, which could establish fault in failed audits and impose sanctions. In turn, the report includes recommendations for improving the current process, specifically in the detection of management fraud. The POB believes that it would be useful if specific guidance were developed based on information learned from previous audit failures. To accomplish that objective, the POB recommends the following:

1. Changingthe SEC Practice Section’s membership requirements to require member firms to modify their quality control Systems to specify that they are taking certain steps in response to allegations of deficiencies in conducting an audit of an SEC client’s financial statements made as a result of litigation against the firm or its personnel or in any public proceeding or investigation by a regulatory agency. Those steps would include a complete internal analysis of the audit; assessment of the capabilities of senior audit personnel; identification of problems with the firm’s quality control system and training activities; identifying the implications of the allegations on the adequacy of auditing, quality control, accounting standards, and guidance for conducting the audit; and communicating those implications to the QCIC.

2. Amending the peer review performance standards to require peer reviews to test the compliance of firms with the modifications to their quality control systems discussed in No. 1 above.

3. Modifying the QCIC’s procedures to require it to develop additional procedures based on the above information reported to the Committee as required in No. 1 above to facilitate resolving audit practice issues and formulating practice guidance in a retrievable format, similar to that of the FASBs Emerging Issues Task Force.

The AICPA supports the POBs recommendations for strengthening the profession’s self-governance. In addition, it recommends that the profession strengthen its system for disciplining those guilty of substandard work or professional misconduct. That system would apply to firms auditing SEC registrants or other publicly accountable entities. I t would be national in its scope and would be overseen by the government. Under that system, cases would be investigated and disciplinary action taken regardless of legal proceedings. Fines would be imposed and the loss of the privilege to audit publicly accountable

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entities would be overseen by an appropriate regulatory body. However, the AICPA recommends that information gathered and the findings from those proceedings should not be admissible in civil proceedings. The AICPA also suggests that one proceeding before a professional body with enforcement powers within the private sector should eliminate parallel, sequential, or multiple investigations and proceedings by various bodies, such as the SEC, the QCIC, or a state board of accountancy.

IMPROVING STANDARDS The report discusses the “expectation gap” and the various reasons

for the erosion of the public’s confidence in the accounting profession, its standards, the relevance of its work, and the financial reporting process. One stated reason for that lack of confidence is users’ unreasonable expectations of financial statements and the auditor’s report. While the POB believes it is unreasonable for users to expect auditors to guarantee the honesty and integrity of the information in financial statements or to warrant management’s honesty and competence, users should be able to get some measure of additional assurance that the company conducts its affairs in accorhance with laws and regulations, its internal controls meet the criteria specified by the Committee of Sponsoring Organizations of the National Committee on Fraudulent Financial Reporting, and management is not committing fraud or manipulating the financial statements. The POB believes that the expectation gap could be narrowed if the profession would improve its standards and practices) including the ability to detect management fraud.

On the other hand, the POB believes the public needs to understand that some information in financial statements is based on estimates rather than on hard numbers. To deal with that misunderstanding, the POB recommends that the FASB design a brief statement, which would be included in all financial statements prepared in accordance with generally accepted accounting principles, to explain the limitations of financial statements.

The report points to the profession’s controversy on the merits of a“current value” reporting model versus the “historical cost” reporting model as another reason for the erosion of the public’s confidence in the profession. The POB, therefore, recommends to the FASB that it add a project to its agenda to study the merits of both reporting systems and either change financial reporting to a value-based accounting model or explain why that change would be impractical and inappropriate. Such a project would consider financial reporting projects now in process at the Financial Executives Institute and the Association for Investment Management and Research and the work of the AICPA’s Special Committee on Financial Reporting, which is examining changes to the existing accounting model and expects to complete its work within a year.

Another POB recommendation related to accounting standards would clearly affect reporting by all companies. The POB contends

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that although many believe that FASB Statement No. 5, “Accounting for Contingencies,” requires companies to disclose material risks and uncertainties, few auditors or preparers have interpreted it as such. The POB and the AICPA’s board of directors both urge the AICPA’s Accounting Standards Executive Committee to adopt its proposed statement of position, “Disclosure of Certain Significant Risks and Uncertainties and Financial Flexibility,” which would mandate such disclosures.

The POB’s final recommendation in the standards area is addressed to the AICPA’s Auditing Standards Board, asking it to revise the auditor’s standard report to clarify the prosljective nature of certain accounting estimates and to include a caveat that estimated results may not be achieved. The POB recommends that the statement be a “realistic and reasonable explanation of the limitation of assurance that can be provided on certain accounting estimates.”

IMPROVING THE PREVENTION AND DETECTION OF FRAUD

The POB makes two recommendations that deal with thedetection of management fraud. Although the public believes this animportant goal of an audit, the profession has viewed it as secondary to other goals. First, the POB recommends that accounting firms assure that auditors are consistently exercising the professional skepticism commensurate with their responsibility to detect and report errors and irregularities. Second, the POB recommends that the Auditing Standards Board, the Executive Committee of the SEC Practice Section, or some other body develop guidelines for assessing the likelihood that management fraud is occurring and additional audit procedures to deal with an increased likelihood ofmanagement fraud.

The AICPA board of directors acknowledges that it is the auditor’s responsibility to detect fraud and endorses proposed federal legislation known as the Financial Fraud Detection and Disclosure Act, which would require auditors to notify the government early of a client’s possible illegal activity. The AICPAalso supports the recommendations of the Public Oversight Board’s recommendations in this area. Further, it recommends that managements emphasize ethical values throughout their organizations and that management, its advisors, such as attorneys, and regulators possessing knowledge about suspected fraud should communicate that information to the company’s auditors so they can confirm or dispel those suspicions. The AICPA states that the profession will establish a process, as suggested by the POB, to review past cases of fraud and disseminate the results to the profession so auditing can be improved.

AUDITOR INDEPENDENCE The report notes that the profession has at times been criticized

for its advocacy of clients’ positions. Some in the profession would consider that to be a matter of client service, but the POB believes the two can be distinguished stating that an auditor providing client

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service should serve the client’s best interests without conflicting with professional standards, the best interests of the audit function, or the auditor‘s best judgment. Accordingly, the POB recommends that the AICPAsharpen that distinction and incorporateit in its Code of Professional Conduct, and that individual firms constantly review their firms’ actions in that area.

Accounting firms have been criticized for client advocacy with standard setters and regulators. That is, some believe that accountants have (1) let their clients’ views bias the firm’s responses to FASB proposals and (2) supported client positions with regulators, such as the SEC, that were unreasonable applications of generally accepted accounting principles or not warranted by the economics of the transaction. The POB believes that such criticism raises questions about the profession’s objectivity, independence, and professionalism. To deal with those criticisms, the POB recommends that an accounting firm’s participation in the standard setting process be objective and professional and that standard setters and leaders of the profession address issues related to client advocacy in the standard setting process and develop methods of identifying and correcting aberrant behavior. Further, it is recommended that accountants ’consult at appropriate levels within their firms before discussing accounting issues with the SEC staff.

To bolster the public’s confidence in auditors’ independence and the audit process, the AICPA recommends that the SEC and other regulatory bodies prohibit public companies and other organizations accountable to the public from hiring the partner responsible for the audit for one year after that partner’s association with the client ends. Another AICPArecommendation in this area is that audit committees of SEC registrants and other publicly accountable organizations be composed, if possible, only of independent directors. Audit committees should be responsible for overseeing the financial reporting process and appointing the independent auditors.

CORPORATE GOVERNANCE The report stresses the fact that financial statements are the

responsibility ofmanagement and that fraudulent financial statements for which auditors are held responsible were prepared by executives who deliberately committed fraud. The POB believes that audit committees, or the board of directors if there is no audit committee, should take on more responsibility for the financial statements of SEC registrants and makes several recommendations in that area. One recommendation would require audit committees to review the annual financial statements; discuss them with management and the independent auditor; receive from the independent auditor all information that the auditor is required to communicate under accounting standards; evaluate the completeness of the financial statements and their consistency with known information; and evaluate whether the financial statements are based on appropriate accounting principles. The POB recommends further that the SEC

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require registrants to include in the document containing the annual financial statements a statement from the audit committee (or board of directors) describing its responsibilities, how they were dis- charged, and whether the steps in the previous recommendation were taken.

The report notes that companies often negotiate for the lowest audit fee without considering how it will affect the quality of the audit. The POB, thus, recommends that the audit committee or board of directors be satisfied that the fee negotiated will be sufficient to ensure that the audit will be comprehensive and complete.

The AICPA supports including a statement in annual financial statements that describes the responsibilities of the audit committee and how those responsibilities were discharged.

REPORTING ON INTERNAL CONTROL The issue of whether to include a report on the effectiveness of a

company’s internal control structure in annual financial statements has been discussed for some time. Regulators have been enthusiastic about such proposals, and guidance on the components of a good system over financial reporting has been issued by the Committee of Sponsoring Organizations in the document, ‘Tnternal Control- Integrated Framework.” Also, the Auditing StandardsBoard is working on performance and reporting standards that would provide for assurances on management’s assertions about internal controls over financial reporting. The POB believes that the public will benefit from such reporting because auditor evaluation of internal control systems will result in improvements to those systems and management’s demands for conformity with the systems will make management fraud andmanipulation more difficult. The POB recommends that the SEC require registrants to include with the annual financial statements a report from management on the effectiveness of the entity’s internal control system for financial reporting and a report by the independent auditor on the system. The AICPA supports these recommendations and urges the SEC to establish such a requirement.

However, the report points out that unless the public understands the scope and limitations of internal control systems, another expectation gap may be the result of such reporting. The POB, therefore, recommends that the Auditing Standards Board establish standards that would clearly communicate to third parties the limits of assurances of auditors’ reports on the adequacy of clients’ internal control systems.

CONCLUSION The recommendations made by the Public Oversight Board and

the AICPA are very controversial. For example, many companies and organizations reject the recommendation that management and its auditors be required to report on the entity’s internal control structure because of the additional cost of doing so, especially for small and medium size public companies. However, most of the largest accounting

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firms support this recommendation and many of the POB’s and AICPA’s other recommendations.

We support the recommendations related to dealing with the litigation crisis, various proposed disclosures dealing with the limitations of financial statements, and those related to the responsibility of audit committees. However, we believe that the cost burden of reporting on internal control may be excessive for small and medium size companies. We therefore urge the standard setters to move cautiously and evaluate the cost-benefit relationship and other ramifications of each of the recommendations. +

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